This article describes the principles of planning dividends and shaping the tax-effective shareholding structure for Latvian companies.
More than a year has passed since the entry into force of the new Corporate Income Tax Act on 1 January 2018 and questions have piled up about not only distributing “old” profits but also “new” profits into dividends.
As questions are still being raised on this subject, we have prepared a summary on the taxation of profit distribution. First of all, we will consider the regulation of dividends in commercial law, then the application of corporate income tax and the application of income tax both to the retained earnings generated by 31 December 2017 and the profit generated as of 1 January 2018.
Dividend regulation in Commercial Law
Let us start with the regulation of Commercial Law, which has not changed as a result of the tax reform.
Article 161 of the Commercial Law stipulates that dividends are determined by a decision of the shareholders, they are paid to the shareholder in proportion to the nominal value of the shares held by him. Dividends are determined by a decision of the meeting of the shareholders, they are paid to the shareholder in proportion to the nominal value of the shares belonging to him, calculated and payable for the fully paid shares.
Dividends may not be determined, calculated and paid, if it is apparent from the annual report or from the review of the economic activity dividends referred to in Section 161.1 of this Law that the company’s own capital is less than fixed capital. Therefore, the payment of dividends does not require the availability of funds which can be paid out in dividends.
The Commercial Law (Part 5) determines that dividends must be paid only in cash on the basis of a decision on the distribution of profits. And (Part 6) provides for a limitation period: dividends which have not been withdrawn within 10 years should be transferred to the company, except in cases where, appropriately to the law, the limitation period is deemed to have been terminated or suspended. In the case of dividends not withdrawn at the time, if this is due to the fault of the shareholder, no interest should be paid. The decision of the shareholders of the company that the dividends may be temporarily held by the company should not be valid. The company may not claim the dividends received from the shareholder, except in the cases referred to in Section 162 of this Law.
From the Commercial Law, we conclude that dividends are payable only in cash, as well as Commercial Law incentivises the payment of dividends, which means that the rights of members to distribute dividends and to leave them at the disposal of the company are limited.
The statutes of the Latvia commercial company may provide that dividends may also be determined and calculated from profits earned during the current year period (after the end of the previous reporting year), the so-called extraordinary dividends.
The board of the commercial company should prepare an economic activity report for the period for which the extraordinary dividends are determined. The Meeting of Participants may not determine a higher proportion of the dividend payout that is determined by the Board. In any case, no more than 85% of the profits earned during the period for which they are set up may be paid in extraordinary dividends.
Corporate Income Tax
Profit realised from 2018
The first question, often asked about the profits earned in 2018, is what dividends should be declared in the distribution of profits: gross or pre-tax or net, those that remain after tax.
It must be said that the answer is that the question is not correctly worded, for the reason that retained profits are distributed under the Commercial Law. The distribution of profits therefore takes place regardless of the provisions of the Corporate Income Tax Act. The application of the tax is a secondary issue. Consequently, if an company has retained profits of EUR 100 000 in 2018, it is entitled, in accordance with the rules of the Commercial Law, to distribute all EUR 100 000 in dividends.
Section 4, Paragraph 2, first paragraph, point (a) of the corporate income tax law provides that the corporate tax taxable base includes taxable objects, including calculated dividends, including emergency dividends.
At this point, two definitions of “taxable base” and “taxable object” are almost unnoticed. The relationship between these definitions is given in the ninth paragraph of this Article, i.e. “When determining the taxable basis for the taxation period, the value of the subject to corporate income is divided by a coefficient of 0,8.”
Mathematically it can be defined by the following formula:
Tax base = tax object: 0,8
or by clarifying our question
Taxable dividend value = declared dividend: 0,8
So if you had a profit of EUR 100 000 in 2018, you can split it all into dividends and pay the tax of 25 000 = 100 000: 0.8 x 20%. And here we come to the first interesting thing that the law allows you to break down the full profits of the accounting year by paying corporate income tax on it next year. Consequently, if the company had a profit of EUR 100 000 in 2018, it may be distributed in dividends in January 2019 and thus EUR 25 000 of corporate income tax will be reflected in the 2019 profit or loss account. That means corporate income tax will cut its 2019 earnings. The shareholders’ decision therefore states that all profits of EUR 100 000 are distributed.
On the other hand, if in mid-2018 exceptional dividends were distributed, let us say EUR 80 000, and a tax of EUR 20 000 was paid, then after the end of the reporting year there is nothing to share, because the profit is 0. This means that it is more profitable to split profits by the end of the reporting year than by the middle of the reporting year.
Flow – through dividends
Dividends received by the Latvian company from a foreign company and distributed further, i.e. the so-called flowing dividends are not taxed if they are further distributed. In accordance with part 6 p .1 of the corporate Income Tax Law: “The taxable person is entitled to reduce the amount of dividends included in the taxable base during the taxation period to the extent that the taxable person has received dividends during the taxation period from the dividend payer who is a corporate tax payer in his country of residence, or such dividends from which they are deducted in the State. tax, other than dividends, received from a person located, established or established in low-tax or tax-free countries or territories.’’
Read here in detail about the taxation of the flowing dividends : here.
Profit earned by 31 December 2017
If a participant is a legal entity, there is no restriction to distribute the dividend in respect of the distribution of profits that occurred before 31 December 2017. Thus, corporation tax is considered to have been paid by submitting a declaration for 2017.
Profit earned from 1 January 2018
In accordance with Section 9 (21) of the Law On Income Tax, dividends, dividends comparable to income or notional dividends if, in respect of calculated dividends, income equivalent to dividends or notional dividends at the level of an undertaking, from the part of the profit from which dividends are paid, dividends are equivalent to income or notional dividends, if one of the following conditions is fulfilled:
- Corporate income tax has been paid in the Republic of Latvia in accordance with the Corporate Income Tax Act (this exemption does not apply if the corporate income tax has been paid in accordance with the Law On Corporate Income Tax);
- A corporate income tax has been paid in a foreign state or a tax comparable to it or a tax has been deducted in a foreign state from dividends, dividends equated to income or notional dividends, or a tax equivalent thereto has been deducted.
- p. of the Law on Income Tax. Part 3.6 states that: “For the purposes of applying points 2.1 and 2.2 of Paragraph one of this Section [i.e. the exemption of dividends from income tax]], it is assumed that corporate income tax or personal income tax has been paid if dividends or income comparable to dividends or the liquidation quota is paid by a company established in another Member State of the European Union or in a European Economic Area country, established and operating in accordance with national laws and regulations. The provisions of Paragraph one, Clauses 2.1 and 2.2 of this Section shall not apply if the paying agent of income is located, established or established in the low-tax or tax-free states or territories referred to in regulatory enactments.
Dividends are therefore not subject to income tax if they have been paid by an EU or EEA non-tax company.
Profit earned by 31 December 2017
If the shareholder is a natural person, the transition period should be taken into account – two years, during which the profit generated up to December 1, 2017 is entitled to a previous dividend tax of 10%. According to Paragraph 130 of the Transitional Provisions of the “On the Personal Income Tax” Act: “Dividends and notional dividends paid by the corporate tax payer from profits incurred until 31 December 2017 shall apply a personal income tax rate of 10 per cent for the years 2018 and 2019.”
This means that, as from 1 January 2020, 20% of corporate income tax should be applied in general terms when it is paid to individuals for both the “old” and the new profits.
One of the clients came up with a creative proposal to avoid paying 10% tax, to invest the capital shares of the Latvian company in a foreign holding, and then to make a dividend payment, already paying it to the owner of the capital shares, the company. No matter how attractive it would be, the rules of the law on false structures must be taken into account. In this case, the deployment of a foreign holding between the Latvian company and the owner-to-natural person is likely to be regarded as a false structure.
What to do when there are huge undistributed profits
If the company has a large amount of retained earnings for 31 December 2017, but there is no money to distribute and distribute the profits in dividends during 2018 and 2019, in this case it is possible to split, deduct and pay the 10% personal income tax, but not to pay the calculated dividends immediately but to pay them out gradually within 10 years, taking into account the available the benefits of the funds available. This means that the company will be credited to its members.
What to do when undistributed profits are so huge that it’s not known or it’s possible to generate enough cash in 10 years to pay those dividends? There is a view that calculated but unpaid dividends can be converted into a loan to the public. In my opinion, this is not exactly right, because, first of all, the loan is a reallocation, a fundamental part of its conclusion is the transfer of money or a case of relief. The Civil Law 1941 states that “A loan may also be valid without passing on its own affairs, if the contracting parties agree to leave the borrower to himself as a loan other relievable things that he or she owes to the lender on any other basis’’. The CL therefore allows for the conversion of other property benefits, including dividends, into a loan. However, given that if the profits are broken down into an “advance”, i.e. without confidence that the company will ever be able to generate enough money, I have strong doubts about the possibility of converting the dividend debt against the loan. Let’s imagine a company that makes deliveries to doubtful customers, recognizes income, profits, divides dividends. So there is a paper dividend, but there is no money. Consequently, there is no property value.
How to build a corporate member structure
In conclusion, we will consider an example of how it is advisable to build a corporate (shareholder) structure.
Suppose that three participants are involved in the commercial activity – Jānis Bērziņš (JB), Aivars Spalis (AS) and Ineta Liepa (IL), who belong respectively to the business.
It is worth considering the corporate structure at several levels:
(1) Operating company, i.e. the production of goods and the provision of services. At this level, all commercial activities or only those functions which result in the production of goods or services may be concentrated. Given the realities of commercial activity, it is sometimes wise to separate basic commercial assets, such as key fixed assets such as capital goods, real estate, intangible property – trademarks, patents, know-how, etc. These assets can be placed in a separate company and transferred to the operating entity for use by means of a lease or license agreement. This protects business-important assets.
(2) Holding company. The holding company is important in many respects, it enables it to manage subsidiaries more effectively, to prepare consolidated accounts, and so on. From a tax point of view, the holding company will not, of course, resolve the issue of dividend taxation at the operating company level, the holding can be used both as a management service provider, a financing centre, a holder of intangible property, etc. (taking into account the market value of transactions), which allows the group to be concentrated in one place and, if necessary, to attract additional investors, or it’s easier for an existing investor to exit the “game.”
(3) Intermediary holding. Each investor (individual) may consider setting up their own separate holding companies. What is the benefit? It can first be used as a purse for other investments, in which case an investor wishes to pursue a commercial activity on his own. This will also be useful if the company wants to sell its shares in Holdings SIA. If investments are held for at least 36 months, dividends from capital gains will not be taxed under Corporate Income Tax Act.